Reforming the Reform Act? Chamber of Commerce Ready to Strike Out at Investors

April 10, 2006

Ten years ago, certain business interests pushed mightily to curb what they viewed as “frivolous” securities fraud class actions. The result of their intense lobbying efforts – The Private Securities Litigation Reform Act of 1995 – just had its 10th birthday. Now, instead of simply celebrating their victory, some of the same people who fought so hard for its passage are gearing up to make securities actions even harder for wronged investors to get to court.

In February, the U.S. Chamber of Commerce hosted a seminar featuring speakers from the SEC, the U.S. Chamber Institute for Legal Reform, the defense bar and Sen. Christopher J. Dodd, one of the key backers of the 1995 Act. Rather than highlighting the positive aspects of the Act – most notably the significant rise of institutional investors who have served as lead plaintiffs – the speakers focused on ways to make bringing suits alleging corporate fraud more difficult.

The 1995 Act contains a number of provisions that changed the way federal securities fraud lawsuits had been prosecuted in the past. Congress added a lead plaintiff provision which provides that the court must name as lead plaintiff the person or group of persons that has the largest financial interest in the relief sought by the class. Congress hoped to encourage institutional investors to take a more active role in securities class action law suits. Congress’ hope on that score has been realized in large part. Institutional investors have played a significantly greater role in enforcing the federal securities laws since the 1995 Act went into effect.

Another change wrought by the 1995 Act was that Congress strengthened the pleading standards for securities fraud cases. In essence, the 1995 Act requires a complaint to lay out in great detail each statement or omission alleged to be fraudulent, and explain “with particularity” all facts on which the claims are based. The 1995 Act also requires plaintiffs to demonstrate facts that give rise to a “strong inference” that the defendant acted with the required state of mind.

The 1995 Act made a number of other changes in the law, including the provision of a “safe harbor” for forward-looking statements, a limitation on damages and a specific requirement that plaintiffs prove loss causation. Another aspect of the 1995 Act that has been difficult for plaintiffs’ lawyers is that the Act imposes a stay on all discovery until after the motion to dismiss has been decided. In some cases, the motion to dismiss can take years for a court to decide and critical evidence can be lost.

The changes resulting from the 1995 Act have been significant, but as cases such as Enron, WorldCom and other massive financial scandals since the Act’s passage demonstrate, the law has not cut down on fraud. Indeed, some believe that the 1995 Act actually allowed massive frauds to flourish undetected.

The February Chamber of Commerce meeting provided a glimpse into some possible changes to the 1995 Act that certain interests may seek to put on the legislative agenda in the coming months. Speakers at the meeting focused on several possible areas of reform. Importantly, Senator Dodd told his corporate supporters that if he becomes the Chair of the Senate Banking Committee next year, he will look at the 1995 Act and the Sarbanes-Oxley Act for roll-back opportunities.

The Wall Street Journal reported three possible “fixes” to the current landscape of securities litigation, discussed at the Chamber of Commerce meeting. The first proposal would allow defendants to appeal motion to dismiss (“MTD”) rulings to the appellate court, extending the discovery stay until after the appeal is heard, adding months, if not years, to the wait. The MTD denial triggers the production of documents demonstrating plaintiff’s allegations. As a result, many cases settle at this stage of the litigation. Having delayed production for years with the Reform Act, backers of this proposal seek to double that period with the unheard of provision of a direct appeal. A second proposal seeks to change the way damages to the class are calculated. Rather than estimates of aggregate damages, supporters of a change in the 1995 Act seek to calculate damages in terms of the per-share inflation of a company’s stock price. Contrary to existing practice, which recognizes several legitimate methods for calculating aggregate damages, supporters of this proposal claim that there is no scientifically valid way to measure damages on an aggregate basis.

Third, rather than praising institutional investors for their involvement in prosecuting securities fraud, there is a move afoot to question whether these investors are getting “overcompensated” as a result of litigation. A paper presented at the Chamber of Commerce meeting and drafted at the behest of the U.S. Chamber Institute for Legal Reform claims that the existing litigation rules provide compensation to large institutional investors “even when they have suffered no real economic loss – indeed, they actually may have gained – from alleged securities fraud.” Anjan V. Thakor, The Economic Reality of Securities Class Action Litigation (October 26, 2005) at 20. Thakor claims that because large institutional investors are generally diversified, they break even from trading in securities whose prices are fraudulently inflated – a point with which many institutional investors would likely quarrel.

In the end, it seems likely that a legislative push to amend the 1995 Act will happen. Institutional investors, whom Congress hoped would get involved in securities fraud litigation, have kept their end of the bargain by becoming lead plaintiffs in record numbers. These same institutional investors can be a powerful voice in the upcoming battle. The gains in fighting fraud made by shareholders in the 10 years since the 1995 Act’s passage could be undone with the stroke of a pen.

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